What is Debt Settlement and How Does it Work?

shot of a couple sitting in the living room and using a laptop to calculate their finances

If you’re struggling with personal debt, you might wonder, “is debt settlement worth it?” Debt settlement can seem appealing, and it may be the best choice for some, but you should use it as a last resort. 

In this article, we’ll detail what debt settlement is and how it works so you can make an educated decision about whether it’s the right choice for you.

What Is Debt Settlement?

When you accrue multiple debts with late payments (or stop making the payments all together), your creditors may reach a point where they no longer believe it will be possible to get back everything you owe. When that happens, a debt settlement company can negotiate with your creditors to accept payment of a lower amount in a lump sum. 

 

Debt settlement is not free. You will need to pay the company that negotiated your debt settlement. Your credit score will be severely affected. In most cases, debt settlement is something you should avoid. 

What Kinds of Debt Can be Settled?

Not all debts can be negotiated through debt settlement. Only unsecured debts are eligible. Some of the most common unsecured debt types eligible for settlement are: 

  • Credit card debt
  • Personal loans
  • Medical bills
  • Store cards

 

Debts that are not eligible for debt settlement are: 

  • Student loans
  • Mortgages
  • Car loans
  • Tax debt
  • Self-employment or business debt

What Percentage of a Debt is Typically Accepted in a Settlement?

Generally, a creditor will require about 50% of the debt you owe, but it can range from 30% to 80%, depending on the negotiations. 

Debt Settlement vs Debt Consolidation vs Bankruptcy

These three terms can be confused and misunderstood. Let’s break them down: 

Debt Consolidation

All of your debts are merged into one loan with one interest rate, allowing you to make only one monthly payment on everything.  

Debt Settlement

If you can no longer pay the full amount of what you owe, try negotiating with your creditors. They might agree to accept a portion of your debts paid as a lump sum instead. 

Bankruptcy

You can declare bankruptcy when you’re no longer able to pay debts. All your non-exempt assets are sold, and the proceeds go toward paying what you owe. This will remain on your financial records for 7-10 years. Bankruptcy is a last resort. 

Is Debt Settlement Worth it?

Every situation is unique. In some extreme cases, debt settlement can help people lessen or break free of their debt. For less dire circumstances, debt settlement probably isn’t right for you. 

What happens when you settle on a debt?

It’s important to understand that debt settlement is not a no-strings-attached solution to your financial problems. At the end of debt settlement, you’ll still have to pay a large portion of what you owe.

Remember that the settlement company will also charge fees, usually as a percentage based on the debt you owe. Make sure you do the math to ensure that settlement is actually worth it for you. 

For example, let’s say you owe $10,000. If your creditor agrees to accept 80% of your debt ($8,000), but your settlement company charges a fee based on 25% of your original debt ($2,500), you’ll actually owe more than you started. 

Now that you know what debt settlement is and how it works, consider your options carefully.